Macroeconomics Unit 3: Chapters 29-32

• These notes cover Unit 3 Macroeconomics, focusing on chapters 29-32.
• Ensure that you understand all the terms from the textbook and PowerPoints.
• Be familiar with models from chapters 29-32 including how to label and manipulate them.
• Ensure there's a good understanding of Balance of Payment Accounts.
• Review all homework and classwork for this unit.

Functions Of Money

• A "yardstick" to post prices and record debts is called a unit of account.
• Functions of money include: a unit of account, store of value, and medium of exchange.
• Fiat money has no intrinsic value.
• Fiat money can be used as a medium of exchange, but it is not legal tender.
• Fiat money performs all the functions of money except providing a unit of account.

Federal Reserve (The Fed)

• The Federal Reserve can buy bonds to increase the money supply.
• The Federal Reserve can sell bonds to decrease the money supply.

Banks

• A bank's liabilities include the deposits of its customers.

Money Supply

• If the Federal Reserve buys bonds in the open market, the money supply curve shifts right.
• A change in the price level does not shift the money supply curve
• A decrease in the money supply creates an excess demand for money that is eliminated by rising prices.
• A reserve ratio of 25% means that for a $1,000 deposit, a bank can initially loan out $750.
• A reserve ratio of 25% means that the minimum change to the money supply initially is $0.
• A reserve ratio of 25%, $1,000 deposits leads to a minimum change of $1,000 in bank deposits.
• A reserve ratio of 25%, leads to a maximum potential money supply increase of $4,000.
• A reserve ratio of 25% leads to a maximum potential increase in deposits of $4,000.
• A reserve ratio of 25% means for a deposit of $1,000, the maximum increase to loans is $3,000.
• A reserve ratio of 20% means that for a $1,000 bond purchase by the Federal Reserve, a bank can initially loan out $800.
• A reserve ratio of 20% means that the minimum change to the money supply is $1,000.
• A reserve ratio of 20% means the minimum deposit change in the banking system is $1,000.
• A reserve ratio of 20% leads to a maximum increase to the money supply by $5,000.
• A reserve ratio of 20% leads to a maximum increase to deposits of $5,000.
• A reserve ratio of 20% means the maximum increase to loans is $4,000.
• Banks deciding to hold more excess reserves relative to deposits causes the money supply to fall.
• To counter this, the Federal Reserve could lower the discount rate.
• If the reserve ratio is 20% and banks hold no excess reserves, the Federal Reserve selling $40 million of bonds decreases bank reserves by $40 million.
• This results in the money supply eventually decreasing by $200 million.
• If the reserve ratio is 12.5%, a monetary injection of $100 billion can be created by the Federal Reserve.

T-Account Example (Question 8)

• First National Bank has $5,000 in deposits, a 10% required reserve ratio, and $200 in excess reserves.
• Assets: Reserves = $700, Loans = $4,200
• Liabilities: Deposits = $5,000

Inflation

• To find inflation rate, it is calculated as follows: New Price Level - Old Price Level) / Old Price Level) * 100.
• If the price level rises from 120 to 126, the inflation rate is 5%.
• When the price level falls, the number of dollars needed to buy a representative basket of goods decreases, increasing the value of money.
• If the inflation rate falls, people change prices less frequently and go to the bank less frequently.
• Farmers have historically disliked deflation because they face large nominal debts; falling prices increase the real value of their debt.

Monetary Neutrality

• Most economists believe that monetary neutrality provides a good description of the long run, but not the short run.

Quantity Equation

• According to the quantity equation, if P = 12, Y = 6, and M = 8, then V (velocity of money) = 9.

Government Expenditure

• Printing money to finance government expenditures imposes a tax on everyone who holds money.

International Trade

• Larry, a U.S. citizen, opening a bookstore in Spain counts as investment for Larry and U.S. foreign direct investment.
• NCO = NX (Net Capital Outflow = Net Exports)
• If a country has negative net capital outflows, its net exports are negative, and its saving is smaller than its domestic investment.
• If there is a trade surplus, saving is greater than domestic investment, Y > C + I + G.
• In an open economy, with GDP = $2,450 billion, Consumption = $1,390 billion, Government Expenditure = $325 billion, Investment = $510 billion, and Net Capital Outflow = $225 billion, national saving is $735 billion.
• If the exchange rate changes from 41 Thai baht per dollar to 35 Thai baht per dollar, the dollar has depreciated and buys fewer Thai goods.
• The demand for loanable funds in an open economy comes from the sum of net capital outflow and domestic investment.
• An increase in the real interest rate encourages people to save, increasing the quantity of loanable funds supplied.
• An increase in the U.S. real interest rate induces foreigners to buy more U.S. assets.
• This reduces the U.S. net capital outflow.
• A U.S. resident buying a foreign bond affects the U.S. demand for loanable funds and the supply of dollars in the market for foreign-currency exchange.
• Domestic investment plus net capital outflow is represented by the demand curve .
• The curve relating interest rates to capital flows shows that as interest rates rise, net capital outflow declines.
• If the government of India reduces national saving, its real exchange rate would appreciate, and Indian net exports would fall.
• If U.S. firms desire to purchase more capital in the U.S., the effects are illustrated by shifting the demand curve.
• The initial impact of this change is in panel c to the left and shifting the demand curve in panel a to the right.
• The initial effect of an increase in the budget deficit in the loanable funds market is a shift from c to b .
• In the market for foreign-currency exchange, the effects of an increase in the budget surplus is illustrated as a move from g to i .
• Starting from r2 and E3, and increase in the budget deficit can be illustrated as a move to r3 and E4 .
• Initially, the real interest rates in the United States and Japan are equal to 7%.
• The real interest rate in the United States increases to 8% while the real interest rate in Japan decreases to 6%.
• There will be an increase in funds flowing to the United States from Japan.
• This is because Japanese investors seek the higher real return in the US market.
• The increased supply of yen decreases the relative price of Yen when compared to the US Dollar. Japan thus demands fewer US dollars. This will decrease the demand for yen by US holders of dollars..
• The yen depreciates compared to the dollar
• The depreciation of the yen or the appreciation of the dollar will: Increase U.S. imports from Japan; Reduce U.S. exports to Japan.
• An increase in national savings increases the supply of loanable funds and reduces the real interest rate.
• Because there is a reduction in the US real interest rate (with real rates in the rest of the world unchanged), US financial assets are less attractive, so there will be a decreased demand for US financial assets.
• This decreased demand ofr US dollars results in the international value of the U.S. dollar to depreciate.
• A depreciation of the dollar makes US goods relatively cheaper than foreign goods, so imports will decrease and exports will increase.
• There will be an increase in funds flowing to the United States from other countries..
• The increased demand for Canadian financial assets raises the demand for the Candian Dollar which results in The international value of the Canadian Dollar to decrease
• The Canadian dollar decreases, with the price off imports reducing and the increased price of exports.
• The supply of funds decrease and this resulted in reducing the supply of fund, and thus lowering intrest rates..

Additional Multiple choice and Fill in the Blank Questions to Consider

• In Economies with Ample Reserves, Central Banks do not change the supply of money in order to enact monetary policy, which means you need to Draw a Reserve Market Model for an economy with ample reserves and on the same model indicate how the model would change if the Federal Reserve began to enact EXPANSIONARY Monetary Policy.
• Individuals who have borrowed money at fixed interest rates will gain from unanticipated inflation.
• In an economy with limited reserves, when the central bank sells bonds on the open market, nominal interest rates will most likely increase?
• If the exchange rate between the United States dollar ($) and the British pound (£) changed from $2 per £1 to $3 per £1, and domestic prices in both countries stayed the same, then the United States dollar would appreciate, making United States imports from Britain more expensive
• An appreciation of the United States dollar on the foreign exchange market could be caused by a decrease in United States interest rates.
• Crowding out refers to the decrease in private investment due to increased borrowing by the government
• If the real interest rate in the United States increases relative to that of the rest of the world, capital should flow into the United States and the dollar will appreciate
• Which of the following will cause the United States dollar to depreciate relative to the euro? An increase in household income in the United States
• Assume that the nominal interest rate is 10 percent. If the expected inflation rate is 5 percent, the real interest rate is 5%
• Suppose that the Federal Reserve buys $400 billion worth of government securities from the public. If the required reserve ratio is 20 percent, the maximum increase in the money supply is $2,000 billion
• Suppose that all banks keep only the minimum reserves required by law and that there are no currency drains. The legal reserve requirement is 10 percent. If Maggie deposits the $100 bill she received as a graduation gift from her grandmother into her checking account, the maximum increase in the total money supply will be $900
• Which of the following is NOT a function of fiat money? To be a source of intrinsic value
• In an open economy, an increase in government budget deficit tends to cause the international value of a country's currency to depreciate, and its trade deficit to become larger
• An increase in imports would most likely cause the gross domestic product of a country to decrease in the short run?
• Assuming nominal gross domestic product in a country is $1,600 and the money supply is $400, the velocity of money? 4
• If a central bank significantly increases its sales of government bonds, it is most likely responding to rising price levels (assuming an economy with limited reserves)
• Last year both a borrower and a lender expected an inflation rate of 3 percent when they signed a long-term loan agreement with fixed nominal interest rates of 5 percent. If the actual inflation rate were lower than expected, then the lender would benefit.
• In an economy with limited reserves, the Federal Reserve decreases the federal funds rate by buying government bonds on the open market
• Which of the following describes a typical business cycle in the correct sequence? Peak, recession, trough, and expansion
• If the reserve requirement is 10 percent and the central bank sells $10,000 in government bonds on the open market, the money supply will decrease by a maximum of $100,000
• If a country has a deficit in its current account, there will be a surplus in the financial account (formerly called capital account)
• Which of the following will lead to an increase in the money supply? Open-market purchase of securities by the central bank